Macro Economics: Phillips Curve, Inflation and Interest Rate


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Macro Economics: Phillips Curve, Inflation and Interest Rate

  1. 1. Macro EconomicsInflation, Unemployment & Philips Curve Assignment Report Presented to Mr. Ahsan Rizvi Course Facilitator By Osman Khan (12539) Haris Mumtaz (12606) Zeeshan Valliani (12543) MBA Executive May 6th, 2012
  2. 2. Letter of TransmittalMay 6th, 2012Mr. Ahsan RizviCourse Facilitator Macro EconomicsInstitute of Business ManagementDear Mr. Rizvi,Presented is our assignment report on “Inflation, Unemployment & Philips Curve.” The project involvedsecondary research on the above mentioned topics and is prepared according to the guidelines providedduring the semester.We would like to thank you for providing the guidelines & suggestions which enabled us to complete thisassignment as our final project. We have worked vigorously on this project to bring you the accurate andreliable results.Sincerely,Osman Khan (12539)Haris Mumtaz (12606)Zeeshan Valliani (12543)
  3. 3. Inflation, Unemployment & Philips Curve BACKGROUNDNew Zealand-born economist A.W Philips first put forward the theory of Philips Curve in 1958.He gathered the data of unemployment and changes in wage levels in the UK from 1861 to 1957.He observed that one stable curve represents the trade-off between inflation and unemploymentand they are inversely/negatively related. In other words, if unemployment decreases, inflationwill increase, and vice versa. CONTENTS OF PHILIPS CURVEPhillips Curve explains the inflation phenomenon encompassing two aspects. Those aspects areDemand Pull and Cost Push. The demand pull inflation is caused when an economy faces thepressure created by excess demand as it proceeds towards full employment and beyond. Thecondition of progression beyond the full employment level of output create that extra pressure onthe economy leading to the phenomenon ofinflation . In such a situation the output fails to matchthe demand because of the stringency of full employment. Therefor the only remedy is to clear offthe goods in the market and to achieve this goal the prices of the good are raised. The cost-pushtheory also referred to as the sellersinflation lays down that in an imperfect economy thecompanies set prices of products that are in accord with the mark-up formula. INFLATION, UNEMPLOYMENT AND PHILIPS CURVE• Macroeconomic policies are implemented in order to achieve government’s main objectives of full employment and stable economy through low inflation.We can use Philips Curveas a tool to explain the trade-off between these two objectives.• Philips Curve describes the relationship between inflation and unemployment in an economy.• Inflation is defined by increase in the average price level of goods and services over time.• When there is inflation, value of money falls. A low inflation rate indicates that average price of goods would not rise as high.
  4. 4. The Short Run Philips Curve: Trade-off between Inflation against unemployment • For example, after the economy has just been in recession, the unemployment level will be fairly high. This will mean that there is a labor surplus. • As the economy has just started growing, the aggregate demand (AD) will increase and therefore leading to an increase in employment. In the beginning, there will be little pressure for a raise in wages. However, as the economy grows faster and more people are employed, wages will start rising slowly. • This will increase the firm’s cost of production and the high costs are usually passed on to the customers in the form of higher prices. Therefore a decrease in unemployment has led to an increase in inflation and vice versa. Therefore, we can say that economy can achieve a lower unemployment rate but it comes at the rate of higher Inflation.The relationship we discussed above is a phenomenon in the short-run. But in the long run, sinceunemployment always returns to its natural rate (unemployment rate at which GDP at itsfull-employment level that is, there is no such trade-off).
  5. 5. It is clear that • When unemployment rate is below natural rate, GDP is greater than potential output – Economy’s self-correcting mechanism will then create inflation • When unemployment rate is above natural rate, GDP is below potential output – Self-correcting mechanism will then put downward pressure on price level The Long Run Philips Curve: Trade-off between Inflation against unemploymentChanges in the level of money supply have no long-run real effects; changes in the growth rate ofmoney supply have no long-run real effects, eitherEven though expansionary policy may reduce unemployment only temporarily, policymakers maywant to do so if, for example, timing economic booms right before elections helps them (or theirpolitical allies) get reelectedThe original Phillips curve was downward sloping showing a negative relationship between therate of change of money wages (and, therefore, inflation) and the unemployment rate. As thisrelationship broke down, it was shown that the original Phillips curve only worked in the shortrun. In the long run the unemployment rate does not fall below the natural rate. Hence, the long runPhillips curve is vertical, because any attempt, in the long run, to cut the unemployment rate belowthe natural rate simply causes the inflation rate to rise.
  6. 6. Inflation and Interest Rates The Effects of Inflation on Borrowers and Lenders:The nominal interest rate is the price a borrower pays a lender for two things: • The amount loaned • The devaluing of the money that results from inflationThe real interest rate is the price paid by a borrower to compensate a lender only for the amountloaned. • The forces of demand and supply determine both the nominal and real interest rates.• When inflation is anticipated, the nominal interest rate increases by an amount equal to the expected inflation rate.• The real interest rate remains constant. Inflation and Interest Rates in the United States• A positive relationship has existed between inflation rates and interest rates.• However, the real interest rate has not been constant.Above Figure shows, higher the inflation rate, the higher is the nominal interest rate, other factors remains the same.Relationship between interest rates and inflation across a number of countries